LOCAL GOVERNMENT FINANCE IN OECD COUNTRIES Dr.

Janice Caulfield University of New South Wales Paper presented to Local Government at the Millennium International Seminar February 19th, 2000, University of New South Wales. In OECD countries there has been a growing mismatch between the functional competencies and fiscal responsibility of local government. In all countries local authorities have broad land planning and infrastructure provision powers and provide a wide range of local amenities. Some have functional responsibility for important areas of public spending in education, health and employment services. Continued population growth, especially in urban areas, has seen a steady increase in demand for municipal services. While the last quarter of the Century has witnessed measures of legislative and administrative decentralisation to meet these demands (reforms which have tended to broaden the economic and social functions of local and regional authorities), these measures have not been matched by a decentralisation of financial control. Where financial decentralisation has occurred, it is generally the intermediate governments that have benefitted, often in the name of new federalism(Owens and Norregard, 1991). In those unitary countries without intermediate level governments such as New Zealand and the United Kingdom, the problem of fiscal autonomy for local authorities has not been given a high priority even by reforming governments (Martin, 1991), although the issue was vigorously debated in the UK following the Blair government Select s Committee report on local government finance[1]. The phenomenon of inadequate growth in local government revenue, and the subject of this paper, is common to many OECD countries.

This paper offers a comparative analysis of local government finance in OECD countries. Its aims are twofold: one is to examine the problem of fiscal autonomy for local government2; the other is to compare and contrast selected countries through a descriptive account of patterns and trends in local financial arrangements. The fiscal autonomy of local governments hinges on the degree of discretion or control available to them over their revenue source. Thus the focus here is on revenue rather than expenditure data. Fiscal autonomy has been the subject of long standing debate in the fiscal federalism literature where the problem of vertical fiscal imbalance between the centre and the states has received much attention (Mathews, 1997; Watts, 1996). Vertical fiscal imbalance (VFI) exists where sub-national governments

depend for their expenditure needs on transfers from higher levels of government. The key argument in support of fiscal balance between revenue and expenditure powers (i.e.fiscal autonomy) is that it increases the accountability and responsiveness of sub-central governments. In the economic literature, it is generally agreed that fiscal decentralisation results in a number of economic welfare gains, and that a willingness to mobilise local revenue is the most allocative efficient way of organising public finance (Pola, 1996; OECD 1999). The counter-economic argument, made in the 1950s in a climate of welfare economics (the legacy of which continues to restrain local government fiscal autonomy), was that only central governments could achieve local economic efficiency through policies of fiscal equalisation and redistribution (Tiebout, 1956; Musgrave, 1973).

Diversity in Local Government Finance The most striking feature of local government finance in OECD countries is the amount of diversity that exists. There is wide variation in the proportion of local government spending which is financed from revenue sources under local control. There are variations in the numbers of local taxes, and in the extent to which particular tax bases are allocated to local government. This diversity is explained, in part, by the fundamental differences in the context and functions of local government in the different member states. The diversity of functions reflect the balance between the choiceand agencyroles that local government can perform. In the choice model, local governments may be seen as a means of allowing local communities to make decisions which match their needs and preferences better than centralised decisions could. In the agency model, local government is seen as a vehicle for the implementation of policies and decisions of central government. In this case, central government will wish to see a decision-making process which allows local discretion to be exercised only to the extent that it does not conflict with the objectives of the centre (Smith, 1996). While local governments universally combine elements of both roles, countries will tend more towards one or other of these models. The diversity of contexts has to do with political culture and administrative tradition, so that while some broad grouping of countries can be attempted, there is often as much variation within these groupings as between them. Nonetheless for organising purposes OECD countries can broadly be seen to fit into one of the following categories: i) Nordic countries; ii) Anglo countries; iii) Continental countries (Franco and Prussian models); and iv) Eastern countries (exemplified here by Japan but also including Turkey and Greece). Overlaying this politico-regional grouping is the constitutional dimension where countries are 2

classified as either federal or unitary. ( This latter categorisation has a number of problems, discussed below).

Intergovernmental Transfers and Grants Local governments in most OECD countries rely on intergovernmental transfers for a substantial percentage of their revenues. The constitutional basis on which the transfers to local government are determined varies; some member states (such as Germany) provide such transfers through stable tax-sharing arrangements, while others allocate grants on the basis of discretionary choices by central government (Smith, 1996). Intergovernmental transfers constitute at least 30 per cent of local budgets in many countries and in some (UK, the Netherlands, Ireland) more than 70 per cent (OECD, 1997). Central governments became increasingly involved in the financing of sub-national governments during the 1960s and 70s, initially as a response to growing demands for government services at the local and regional levels and then, in their efforts to confront the problem of growing regional and metropolitan disparities in the 1980s and 90s , through strategies of fiscal equalisation (Caulfield, 1997).

In the current period of financial austerity at the national level, it is now clear these past interventions have placed sub-national governments in a tenuous position. Not only have subnational governments expanded their policy arenas and service provisions but they are now having to find new ways to fund programs in the face of cut backs in grants from central government. Discretionary transfers are a mixed blessing. Faced with restrictive tax policies, local governments rely on central government grants to meet their expenditure shortfalls. Moreover, grants are less politically painful forms of revenue raising, and many local communities depend on their equalising or redistributive effects. The implications for local autonomy will depend on three factors. First, the proportion that grants represent in the total revenue budget of local governments; second, the form in which the grant is given, as a specific purpose or general grant; and third, the formula used for distributing the grant. Beginning in the late 1980s, special-purpose grants became the object of critical examination in some countries. The conclusion was that not only did they violate the right of local selfdetermination, but they led to the inefficient use of local resources (Netherlands Scientific Council Report, 1990). Indeed, an OECD survey in 1983 supported the argument in favour of fiscal autonomy by showing that in countries where local government was not responsible for tax decisions, local expenditures increased more rapidly. The trend in government financial 3

transfers away from specific purpose payments and towards block grants has been a general one in most Member countries. The question is whether the current preference of central governments for general grants is more closely related to their efforts to rein in levels of local expenditure, than to any real commitment to local autonomy.

The Data The analysis which follows uses as its base data OECD country statistics which are collected in an annual publication of the OECD[3]. The main aggregate indicator used by the OECD is the tax-to-GDP ratio, showing the share of tax revenues in Gross Domestic Product[4]. Sources of revenue are divided into three categories; (i) tax, (ii) non-tax, and (iii) grants. There are two major problems with the data as it is currently calculated. One is the standard classification of revenue where the assumption has been that the tax share of local government revenue is a measure of its fiscal autonomy. The tax classification, however, takes no account of local government discretion over locally raised taxes, so that even where local government receives a larger share of total tax revenues of general government, this cannot be taken to mean greater fiscal independence from central government. For example, while Norway and Finland had roughly the same percentage share of general government tax revenue in 1995 (at 20 and 22 percent respectively) local government in Finland can set its own tax rate whereas Norway must accept a centrally determined revenue split. A recent project of the OECD Working Party on Tax Policy Analysis has developed a s framework for further classification of revenue data based on degrees of autonomy of local taxation arrangements. The new classification (still being developed) takes account of a country institutional arrangements which give more or less control to local authorities (see s Appendix).

The combination of all government units operating in a country is typically called general government consisting of four sub-sectors: , i) ii) iii) iv) federal, central or national government; state, provincial, cantonal, or regional governments when they exist within a country; local governments including municipalities, school boards, etc.; and any supranational authorities exercising taxation and public expenditure functions within the national territory(OECD, 1999).

This leads to the second problem with the OECD revenue data which classifies sub-national government revenue as either state or local according to a country constitution as federal or s unitary. Thus, while there is a break down for federal countries between their respective subnational government revenues, there is no similar break down for unitary countries even though many of these have intermediate and multiple levels of government. The revenue data from unitary countries with cantonal or regional governments is classified by the OECD as local even though these intermediate units of government may exercise a competence , independently of central government. The OECD in its turn takes this classificatory system from the International Monetary Fund which probably has less interest in the institutional diversity of government and its ramifications for fiscal policy.

Local Government Finance Compared The following analysis reveals first and foremost the diversity that exists between countries. Yet despite this diversity, some common themes and generalisations can be made, especially about the directions of change in local government finance. These themes indicate what may be some key problems for local government autonomy. However, at this stage of the research, the data is indicative only and more detailed country studies will be needed before any firm conclusions can be drawn[5].

Local Government Total Revenue (tax, non-tax and grants) as a percentage of GDP for the years 1980 and 1995. Denmark local government has the largest income to GDP followed closely by the other s Scandinavian countries, Sweden, Norway and Finland. These countrieslocal authorities are, of course, responsible for major areas of public spending such as health and education, typically provided by state governments in federal countries, and central governments in other unitary countries. The financially poorest of the federal countries are Mexico and Australia. New Zealand fares marginally better than Australia, but as the third poorest of unitary countries after Greece and Turkey, indicates New Zealand strong centralist regime. The next s poorest group of unitary country local governments is Japan, Luxembourg, Iceland and France. The Netherlands, Ireland and the UK are financially stronger; but what is significant here is that when compared to the 1980 data, it is these latter three countries (together with New Zealand) that have lost ground in the 15 year period. Sweden, and to a lesser extent Denmark, also suffered a decline in revenue over the period. 5

There were marginal increases in most federal country local government revenues over the period, while Finland, Spain, Italy, France and Norway made more substantial gains[6].
LOCAL GOVERNMENT TOTAL REVENUE, 1980 AND 1995 ( % OF GDP)

40.0 35.0 30.0 25.0 1980 1995 15.0 10.0 5.0

DEU DEN ESP SWE PERCENTAGE

20.0

0.0
UKD

FIN

SWZ

COUNTRY

Local Government Own Source and Total Revenue, 1995 (as % of GDP) By comparing own sourcerevenue to total revenue we can see the degree of local government dependence on higher levels of government. In light of the above discussion on intergovernmental grants, this is an important comparison for what it says about local government autonomy. Countries most heavily reliant on grants are the Netherlands, the UK, Ireland, Spain and Italy where more than 70 per cent of total local revenue comes in this form. (As newly regionalised countries, Spain and Italy are in a sense special cases). Belgium, Canada, and Denmark depend for approximately half their revenues on grants, whereas for Norway, Luxembourg and the USA grant income is around 30 percent. Australia, Austria, New Zealand and Iceland receive less than 20 per cent of their revenues in grants.

NOR

CAN

NLD

BEL

IRL

LUX

JAP

ISL

AUT

FRA

AUS

USA

NZL

ITA

LOCAL OWN SOURCE AND TOTAL REVENUE, 1995 ( % OF GDP)

PERCENTAGE

40.0 35.0 30.0 25.0 20.0 15.0 10.0 5.0

CHE DEU DEN ESP SWE NOR TUR OWN SOURCE REV TOTAL REVENUE

0.0
BEL CAN AUT AUS

SWZ

USA

COUNTRY

Main Taxes as a % of Total Local Tax Revenues, 1997 There are two main sources of local government tax; these are the income tax and the property tax, but there is a wide range of taxes used by many countries, from use tax to goods and services tax to payroll tax. The income (and profit tax) is, taken overall, the most important tax for local government in the OECD at an average of 41 per cent. This tax takes a number of forms including tax sharing arrangements with higher levels of government (Germany); separate tax rates but a central tax system (Belgium); separate rate and allowance structures (Sweden); and separate tax systems (Switzerland). The property tax dominates the Anglo speaking countries; Australia, for example, is 100 per cent reliant on the property tax. In equity terms, it is seen as a regressive tax in that higher income households pay relatively less tax than lower income households. The advantage of an income tax over the property tax is seen to be its relative progressivity (OECD, 1983). British experience, however, might suggest that a property tax has more to commend it than, for example, a flat rate poll tax which is equally regressive and has resulted in a complex system of rebates (Travers, 1989; Bird and Slack, 1991). In fiscal autonomy terms the property tax has proved to be the most controversial largely because of its inflexibility. It is a highly visible tax and therefore resistant to growth[7]. Large fluctuations in property values can occur and hence, as a source of income for local governments, it is unpredictable. Moreover, it is subject to central government controls in the form of rate capping. Countries with the most diverse tax bases (and therefore

UKD

FIN

FRA

NLD

IRL

LUX

ISL

NZL

ITA

the greatest flexibility) are Austria, Japan and Spain, where these countries have between six and seven different tax bases to draw on.
MAIN TAXES AS A % OF TOTAL LOCAL TAX REVENUES, 1997

1 00%

OTHER TAXES TAXES ON USE SPE GOODS & SERV GENERAL TAXES

80%

PERCENTAGE

60%

40%

PROPERTY PAYROLL

20%

INCOME & PROFIT

0%

BE L CA N DE U SW Z US A

DE N

COUNTRY

Local Government Tax Revenue as a % of GDP 1975, 1985 and 1997 Tax as a source of income for local government in many OECD countries has steadily declined since 1975, most notably in those countries heavily reliant on property tax, and in most federal countries. Britain suffered the biggest losses as a direct result of central government policies under the Thatcher government. But Norway too has lost ground. Growth in tax over the period has occurred in other Nordic and Continental countries and in Japan. As a proportion of general tax revenue, however, Japan has lost ground to central government, as has Finland. Indeed, most countries have reduced their share of tax at the local government level. The notable exceptions are Denmark, France, the Netherlands, Iceland, Italy and Spain.

JA P LU X NL D NZ L NO R ES P SW E UK D

AU S AU T

FI N FR A

IS L

IT A

LOCAL GOVERNMENT TAX REVENUE AS A % OF GENERAL TAX REVENUE 1975, 1985 AND 1997

35 30 PERCENTAGE 25 20 15 10 5 0 DEU DNK NOR SWE SWZ UKD BEL FRA NLD FIN AUT CAN LUX NZL IRL AUS USA ESP JPN ITA ISL 1975 1985 1997

COUNTRY

LOCAL GOVERNMENT TAX REVENUE AS A % OF GDP 1975, 1985 AND 1997

18 16 14 PERCENTAGE 12 10 8 6 4 2 0
AU S AU T BE L CA N DE U SW Z US A DE N FI N FR A IT A JA P LU X NL D NZ L NO R ES P SW E UK D IR L IS L

1975 1985 1997

COUNTRY

Local Government Own Source and Tax Revenue, 1995 as a % of GDP A comparison of own source(ie. local tax and non-tax sources of revenue) with tax only reveals some important differences and patterns among countries. Japan is the only country whose own sourceincome is 100 per cent dependent on tax. Most countries rely for their own source revenue on a mixture of taxes and fees and charges (or non-tax Countries ). which rely most heavily on non-taxforms of income are the Netherlands, UK, Ireland, Austria, Germany, Switzerland and Finland. The downward trend in tax revenue has been partly ameliorated by a substantial shift to non-tax revenue such as user charges. This is especially the case in federal countries. In North America( and increasingly in Australia), user charges are viewed as highly efficient and politically acceptable (Bird & Slack, 1991; Kincaid, 1991). Unless they are pure public goods or the policy intention is redistributive, there is the presumption that local public services should be charged for. To this extent local governments in these countries have demonstrated residual powers of local autonomy (Pierre, 1990). Nontax revenue has less appeal in unitary countries which showed variable results. The exceptions are Finland where non-tax as a revenue source more than doubled between 1980 to 1995. In Norway, the Netherlands, France, Spain and Luxembourg there was growth, but in the UK there was a marked decline as there was in Iceland, Sweden and New Zealand. Privatisation of local government enterprises has been an important contributing factor to the decline in nontax revenue in the UK and New Zealand (Stoker, 1999; Martin, 1991).

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LOCAL GOVERNMENT OWN SOURCE AND TAX REVENUE, 1995 (AS A % OF GDP) 25.0

20.0

PERCENTAGE

15.0

10.0

TAX REVENUE OWN SOURCE REV

5.0

DEU

DEN

ESP

SWE

0.0
BEL CAN AUT AUS

FIN

NOR

USA

COUNTRY

Local Government Fiscal Autonomy Historically, the size of a local government tax share has been seen as a measure of its fiscal s autonomy. However, the OECD now recognises that fiscal autonomy is a more complex matter. According to its Working Party on Tax Policy Analysis, fiscal autonomy is greatest if sub-central governments are free to determine both the taxable base and the rates of a particular tax, without any aggregate limits on revenues, base or rate enforced by the central government[8]. In Table 1 of the working party report s Taxing Powers of State and Local Government 1999 (see Appendix), revenues are organised by degree of tax autonomy using , eight categories as follows[9]. a) b) c) d) sub-central government sets tax rate and tax base sub-central government sets tax rate only sub-central government sets tax base only tax sharing arrangements i) ii) iii) SCG determines revenue-split revenue-split can only be changed with consent of SCG revenue-split fixed in legislation, may unilaterally be changed by central government iv) revenue-split determined by central government as part of the annual budget process e) central government sets rate and base of sub-central government tax[10]

By way of example, we see in Table 1 (Appendix) that New Zealand local government share s of general government tax at 5 per cent is very much lower than Norway which in 1995 s

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UKD

FRA

NLD

IRL

LUX

ISL

JAP

NZL

ITA

accounted for 20 per cent of total taxes, and yet New Zealand level of autonomy is much s greater because it has discretion over both the tax rate and base, whereas Norway has effectively no fiscal discretion. It can be concluded therefore that countries that have both attributes, that is where local government has a relatively large share of national taxation together with high fiscal discretion over that share, have more autonomy. These countries include Sweden, Switzerland and Japan.

Conclusion From the foregoing analysis we see a great deal of diversity in local government financial arrangements around the world. The data shows variations along a number of dimensions. These include whether a country is unitary or federal, whether its tax base is primarily property or income; its level of dependence on intergovernmental transfers, and its discretionary powers over taxation. The overall picture at the end of the millenium is one of fiscal constraint either through reductions in grants or loss of tax revenue and in two cases, Britain and New Zealand, a decline in non-tax revenue as services in these countries have been progressively privatised. Countries especially affected by a loss in taxation are those dependent on the property tax. These mostly Anglo countries have been subject to various central government intrusions such as rate-capping or, even more extreme, central government take-overs as happened in Britain with the business tax. A partial solution for many countries (except New Zealand and Britain which have lost trading enterprises) has been to turn to nontax sources such as user charges to balance their budgets. Central-local decentralisation then must be seen as only partial and ultimately unsatisfactory as long as functional responsibilities continue to be devolved without an appropriate devolution of fiscal autonomy for local governments.

[1]The Environment, Transport and Regional Affairs Committee Report s Local Government Finance(1999). See also Modern Local Government, In Touch with the Peoplethe White Paper, British Government, July, 1998.

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This paper does not enter into theoretical debates on local autonomy which have been more than adequately covered by Harold Wolman and Michael Goldsmith (1992) and Desmond King (1987,1990) [3]OECD. Organisation for Economic Cooperation and Development (1999) Revenue Statistics, 1965/1998. A problem for this paper has been the availability of recent data. The most recent collected data is for 1997 but here it is only tax revenue that is available. Data which includes other sources of income i.e. non-tax and grants is available only for 1995. [4]As a comparative measure there are some limitations on the tax-to-GDP ratio including, for example, the extent to which countries engage in tax expenditures rather than direct government spending; differences in the measurement of GDP between countries; and the economic cycle. [5]The OECD has 28 member countries and growing. Some new members may not be represented in the data because of data gaps from earlier years. The most recent data available is for 1997 but is restricted to tax revenue. Where grants and non-tax revenues are included, the most recent data available is for 1995. [6]Italy and Spain are special cases because of their recently introduced regional governments. [7]A good example of this resistance is the celebrated case of Proposition 13 in the State of California. See O Sullivan et.al. 1995. [8]OECD (1999) Taxing Powers of State and Local GovernmentTax Policy Studies No. 1. [9]The Working Party acknowledges that the classification is still not as finely tuned as it might be. For example, while the classification indicates the greatest level of autonomy, (a) even this does not take account of a central government ability to impose a limit on total s revenues to be raised from owntaxes. Nor does it take account of central governmentsnot infrequent restriction on the band width or range of rates that a local government (otherwise free to set the rate) can establish. [10]The table shows a predominance of type (b) tax; that is, where SCGs set tax rates only. This category averages approximately 9 per cent of total taxes of general government which is exactly half the sub-central government share of total tax. The most important tax base for this predominant category (b)is income and profits tax (OECD, 1999).

REFERENCES Bird, R. and E. Slack (1991) Financing Local Government in OECD Countries: the Role of Local Taxes and User Chargesin J. Owens and G. Panella (eds.) Local Government: an International Perspective (North Holland: Amsterdam) Caulfield, Janice (1997) Finance, Taxation and Equity within Metropolitan Areas Paper . presented to the OECD/Sweden Workshop Governing Metropolitan Areas: Institutions, Finance and Partnerships. Stockholm, 4-6 June. Martin, J. (1991) Devolution and Decentralizationin J. Boston et.al. Reshaping the State: New Zealand Bureaucratic Revolution (OUP: Auckland) s

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Mathews R. and B. Grewal (1997) The Public Sector in Jeopardy: Australian Fiscal Federalism from Whitlam to Keating (Centre for Strategic Economic Studies: Victoria) Musgrave, R.A. (1973) Public Finance in Theory and Practice (New York: McGraw Hill) Netherlands Scientific Council for Government Policy (1990) Institutions and the City: the Dutch Experience OECD (Organisation for Economic Cooperation and Development) (1999) Revenue Statistics 1965/1998 Special Feature _______ (1997) Managing Across Levels of Government PUMA _______ (1983) Taxes on Immovable Property (Committee on Fiscal Affairs and the Ad Hoc Group on Urban Problems) O Sullivan, A. et.al.(1995) Property Taxes and Tax Revolts: the legacy of Proposition 13 (Cambridge University Press) Owens, J. and Norregaard, J. (1991) The Role of Lower Levels of Government: The Experience of Selected OECD Countriesin J. Owens and G. Panella (eds.) Local Government: an International Perspective (North Holland: Amsterdam) Pola, G. et. al. (1996) Developments in Local Government Finance (Edward Elgar) Pierre, Jon (1990) Assessing Local Autonomyin King, D.S. and J. Pierre Challenges to Local Government (Sage) Smith, S. (1996) European Integration and Local Government Financein Pola op.cit. Stoker, G. (1999) The New Management of Britain Local Governance (Macmillan) s Teibout, C.M. (1956) pure theory of local government expendituresJournal of Political A Economy, vol. 64:5 Travers, T. (1989) Community Charge and other Financial Changesin J. Stewart and G. Stoker (eds.) The Future of Local Government (Macmillan:London) Watts, R.L. (1996) Comparing Federal Systems in the 1990s (Institute of Intergovernmental Relations: Kingston)

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